The Sensex has rallied 16 per cent since May on the back of strong buying by foreign institutional investors.

If you thought that's reason enough to celebrate, take a look at this before you cheer.

Year to date, the Morgan Stanley Capital International India Index, against which FIIs benchmark their performance, has gone nowhere -- it gained less than 1 per cent in dollar terms.

On the contrary, the MSCI Emerging Markets Free Index surged 14.8 per cent during the period.

Look at the individual markets, and the result is even more depressing -- every single market has done better than India, barring Hungary, which turned in a marginally negative return.

Clearly, India is not a hot destination for the FIIs yet. Reason: While a handful of Indian stocks figure in the fund managers' radar, India as a country is still not fancied. Is that set to change? A wee bit, perhaps.

Says Samir Arora, Asia Pacific head of Alliance Capital Investment  Managers: "Driven by factors like a strong currency, an improving geopolitical environment, reforms in key sectors like banking, power and telecommunications, privatisations and stable policies, I expect a growing class of investors to come here because they are attracted by India per se and not just by the few companies that their analysts have discovered in India."

Despite India's low weight of 4.9 per cent in the MSCI EMF -- significantly lower than that of China, Korea, Taiwan and Malaysia in the Asian region, apart from South Africa and Mexico -- top research firms are overweight on India.

For instance, Merrill Lynch's Global Emerging Market portfolio for May 2003 recommends an allocation of 6.4 per cent to India. It is overweight on other countries including Russia (7.9 per cent), Indonesia (3.5 per cent), South Africa (15 per cent) and Hungary (3 per cent).

Not surprising, since Indian equity valuations still appear to be one of the cheapest in the region. The market trades at a forward P/E multiple of 8.5, the cheapest after Philippines in the Asian region.

There are other reasons too for this relative bullishness on India. It is the fastest growing economy in Asia, promising a growth of over 5.5-6 per cent if the rain Gods are benevolent. An increase in rural demand will drive stock market performance as well.

As opposed to this, India's economic rivals in the region are actually reeling under SARS, especially China, a market that has impressed investors because of it sheer ability to grow at a faster clip.

Economists forecast that SARS could shave off about 2 per cent from China's GDP growth. For the entire region, GDP growth is expected to be lower by 0.75 per cent in 2003.

That's not all. India's booming IT and IT-enabled services have put the country on a different pedestal.

The recent outsourcing backlash in many countries only goes to prove India's competitiveness further -- so much so that business has attracted the attention for the most powerful nations.

On the external front, it has never been so good. Forex reserves stand at $74 billion. Riding on easy liquidity and the weakness of the dollar, the rupee ended last year with a gain. This year is likely to be no different.

That's a big plus for investors in Indian markets. Says Chetan Sehgal, vice president, Templeton Emerging Markets Group, "For a global investor, the  dollar reserve situation is a key criterion for evaluating a market and healthy reserves are a big plus for India."

For global investors, the strength of the local currency is of utmost concern as it can eat into their returns significantly.

Besides, corporate restructuring has also gathered pace. Even in corporate governance, India scores better.

"India is far better than many other Asian markets in terms of disclosures, transparency and other corporate governance parameters," adds Bhat.

But the problem is. . .

If all the pluses don't add up to an explosion of interest in Indian equity, the biggest reason is that of fiscal deficit.

"Fiscal deficit is a major concern for global investors" says Bhat. "Unless, the government makes serious efforts at fiscal consolidation, foreign investors may not be confident of India" says Sehgal.

Another issue is market size. Despite the fact that there are about 6,000-and-odd companies listed on the Indian bourses, the Indian markets are small in size compared with many others in the region.

On May 30, Hong Kong, the largest market in Asia, had a market-cap of $444 billion. Taiwan had a market cap of $188 billion, Korea $179 billion and China $115 billion. India had a market-cap of only $99 billion.

India's market-capitalisation to GDP ratio of about 20 per cent is still among the lowest in the region. That itself poses a limit to FII investments.

Having said that, it is quite possible that India may get a larger share of FII money this year. One key reason is that portfolio investment in emerging markets till 2002 was propelled by a large number of sizeable new equity issues.

However, this has slowed to a trickle since then. Total equity placements were only $6.7 billion in 2002, compared to the peak of $28.5 billion in 2000; nearly a third of these flows were to China, which sold a few of its large public enterprises.

The lack of new issues, may mean opportunity for India, especially if the government is able to forge ahead with some divestments this year.

Says Bhat, "The success of the Maruti IPO has changed the rules of the game. If the government is able to maintain the pace of divestment, we could see significant inflows."

Most countries have seen a rerating only on account of government initiatives or a change in perception about governments. Look at Brazil.

Foreign investors have shown renewed confidence in Brazil's leadership after the new president pledged to maintain monetary policy and fiscal stability. Year to date, the Brazilian stock market has surged about 31 per cent. Ditto with Turkey.

Renewed interest in emerging markets: Last year, the performance of emerging markets was flat. But compared to developed markets, they fared better.

This year, indications are that fund flows to emerging markets will be higher.

The International Institute of Finance forecasts that net portfolio equity investments will increase to $6 billion from net outflows of $3 billion last year.

As things stand, US GDP is projected to grow by 2.4 per cent this year and about 3.6 per cent in 2004. For Japan and the Eurozone, growth is likely to be slightly better this year, but still below 1 per cent.

Most emerging economies should exhibit stronger growth than that. These pluses come with a fair share of evils. Many emerging economies are still reeling under huge debt burdens, high inflation, unacceptable levels of deficit and unstable currencies.

And then, there are geopolitical risks like the recent instability in the Middle East, the threat of terrorism and SARS,  which has affected south-east Asia badly.

For investors, the other important concern is corporate governance standards. Still, there are enough opportunities to make money. Net-net, stocks are  going cheap in emerging markets.

The aggregate price-earning (P/E) multiple in the emerging markets is half that of S&P 500, the lowest valuations in the last decade. The only downside to emerging markets fund flows could be a possible slippage in the US growth numbers.

Where will the big money flow?

As per IIF estimates, Latin America will lead the pack in emerging markets.

• Net portfolio equity investment in the Asia-Pacific region is expected to rise to about $4 billion in 2003, from about $2 billion last year.

Last year's relatively low inflows were primarily the result of declining portfolio equity investment in South Korea as foreign investors sold shares after Korea's 35 per cent stock market surge from December 2001 to mid-April 2002.

Most countries in the region are expected to see modest net inflows this year, except for the Philippines.

• Latin America's portfolio equity investment flows are expected to shift from $3 billion net outflows in 2002 to $100 million net inflows in 2003, as last year's withdrawals from much of the region are expected to stop.

A slight pickup in net inflows to Argentina, Brazil, and Mexico is likely. This year would be the first year of net portfolio equity inflows after five consecutive years of net outflows from the region, reflecting expectations of greater stability in the region.

• A modest shift in portfolio equity investment to net inflows of around $1 billion in emerging Europe is expected this year, from last year's $1.2 billion net outflows.

While most markets are likely to see a slight inflow this year, Poland's turnaround from an estimated $1.2 billion outflow over the past two years (due to the bursting of the stock market bubble) to this year's modest inflow of $50 million is the largest contributor to the expected positive shift in net portfolio equity investment.

Having said that, much of the portfolio investment could actually flow into the smaller countries, as they are expected to show faster growth and trade at relatively attractive valuations, say some foreign fund managers.

MSCI data on emerging markets have a trailing P/E of 13.4X, compared to 23.7X for world equities, and a trailing price-to-book value multiple of 1.39X compared to 2.16X for global equities.

Emerging markets' return on equity is also higher than that of global equities. Foreign investors are also hopeful of government initiatives to stimulate growth this year.

Last year, smaller markets like Russia, India, Thailand, Israel and South Africa outperformed the larger ones like Korea, Taiwan and Mexico.

The year-to-date market performance also reaffirms this view as smaller countries continued to gain more than the larger ones. India is in with a chance.

'India should see a growing class of foreign investors,' says Samir Arora</B>, head, Asia Pacific, Alliance Capital Investment Managers.

Year to date, the Bombay Stock Exchange Index is up a paltry 1.2 per cent. In dollar terms, it is up 0.95 per cent. Considering that in the previous three calendar years the Sensex was up 3.5 per cent, down 17.8 per cent and down 20.6 per cent; this does not look too bad.

Compare this to the year-to-date performance of other markets in the region or indeed the world, and you start feeling a bit uneasy -- China up 16.79 per cent, Taiwan up 15.62 per cent, Thailand up 33.12 per cent and Indonesia up 31.09 per cent. You want to feel depressed -- see Pakistan, up 8.54 per cent. You are a real glutton for punishment -- look at Argentina, up 50 per cent.

Year to date, India has seen net FII flows of  $600 million till end of May. Despite our market's fascination with FII flows there is no evidence that FII flows determine the direction of the market.

In the current year, Korea, Singapore and Taiwan have had net negative flows from foreign investors and these markets have still done much better than our own market.

Net foreign flows into Hong Kong for the first five months of the year are of the order of only $19 million despite its much larger size and the market has still outperformed India year to date.

Alliance Capital and many other investors around the world remain hugely overweight on India despite this seemingly poor performance.

The main reason for our continued confidence and faith -- India remains a stock pickers' market and the performance of the broader market is actually not as bad.

Stock picking has been rewarded this year quite handsomely -- stocks in many sectors like banking, automobile and engineering have richly rewarded investors.

On an index basis, India's weightage in the relevant Asian and emerging market benchmarks is abysmally low.

It may be surprising for many investors to learn that the weightage of even individual companies like Samsung Electronics is much higher than that for India as a whole in the MSCI indices followed so widely by institutional investors. 

As India privatises more companies and larger market capitalisation companies appear on the investment horizon, global investors will need to focus more on India.

In the meantime, India gets attention of primarily dedicated Asian and emerging markets funds who almost uniformly swear by the high quality bottom-up choices available in India.

India also has two unique sectors within an Asian context -- pharmaceuticals and software which can attract a lot of investor interest.  

Jean Rostand said so many years ago, "Merit envies success and success takes itself for merit". India has enough merit but we still envy the success of other countries.

It is not clear that the economic business models of other countries (like China) will be as successful in the long term.

India with its slow but steady and transparent progress is actually winning more friends and admirers than we would have imagined a few years ago. 

India has made a lot of progress in recent months in carrying out key reforms in banking, power, etc.

But much more needs to be done in areas like fiscal discipline, attracting more investments in infrastructure and privatising large ticket companies. 

Is the current interest in India temporary? I do not think so. So far, India has attracted investors who come and invest here because they like the bottom-up stories of our market (like HDFC, Reliance and Infosys). 

An equally important class of investors who look at the world on a top down, macro basis have traditionally bypassed India.

Driven by factors like strong currency, reforms in key sectors like banking, power and telecommunications, privatisations and stable policies, I expect a growing class of investors who would come here because they are attracted by India per se and not just by the few companies that their analysts have discovered in India. 

Why India should gain

Net portfolio equity investment in emerging markets is likely to increase $6 billion from net outflows of $3 billion last year.

Year to date India has lagged behind the MSCI Emerging Market Asia Index (11%). MSCI India gave a return of 0.94%, but the macro and the micro picture indicates foreign investors have a reason to look at India favourably.

• Fastest growing economy in the world; GDP growth projected at 5.5 per cent.
• Attractively valued compared to other emerging markets; 2003 forward P/E at 8.6 compared to 12.6 for Asia Pacific.
• Maruti IPO success raises expectations. Government divestment programme could attract foreign investors
• A strong currency promises better returns in dollar terms.

Risk

• If US recovery does not happen in the second half, emerging market fund flows could be affected.
• Indian government's inability to maintain the pace of divestment, move towards fiscal consolidation.